Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Fund Talk Are Income Trusts Fixed Income Or Equity? Rachel Michaud I ncome trusts are currently the fastest growing product in the Canadian investment industry. Low interest rates and, until recently, weak equity returns have greatly contributed to the popularity of income trusts. The Canadian income trust market has grown from 26 billion dollars in 2000 to approximately 60 billion dollars in 2003. The number of income trusts listed on the Toronto Stock Exchange has doubled in the past three years. With an average yield above 9%, investors have been attracted to income trusts by their high distributions. Additionally, income trust investments provide tax-saving benefits, which increase the value of a firm converting to an income trust. Some companies have seen their stock price jump as much as 30% on the news of their trust conversion. Income trusts are mainly created by companies and private firms to raise capital. Good candidates for trust conversion are stable businesses, relatively mature, and with predictable cash flows. The income trust structure was developed to facilitate distributions to investors on a tax-efficient basis. Traditionally, resource and real estate firms dominated the income trust market. As the income trust market is growing, companies in other sectors are joining the resource and real estate companies and converting into trusts. This structure is well suited for maturing industries with a low growth rate. Despite the popularity of income trusts, few investors really understand the risks of this type of investment. Many investors even describe income trusts as fixed income like bonds but in reality income trusts have much more in common with equities. In this article, I will examine the risks involved with investing in income trusts and discuss how investors can minimize those risks. Income trusts are similar to bonds because they pay a fixed amount at regular intervals. Just like bonds, the higher the income trust yield, the higher the risk. Both bonds and income trusts are sensitive to interest rate movements but the similarities end there. The risk profile of bonds and income trusts is very different. Income trust distributions are not guaranteed and can fluctuate. Distributions are paid from earnings but can include a portion of the initial capital (principal or investment amount) invested. The return of the initial capital decreases the cost base of the income trust. Unit holders do not pay any tax on the portion of the yield representing the return of capital. The capital gain is deferred until the units are sold and is calculated using the cost base adjusted downward by the amount of capital returned. When you are getting part of your initial investment back, the actual return (percentage) from the income trust will be lower than the income trust yield. Higher yield income trusts do not mean that they have the best returns because a higher payout may mean that the income trust is making some or most of its distributions from return of capital. Some investors make the mistake of thinking that the yield from an income trust is the actual return. If the income trust yield is greater than its actual return, distributions will have to be decreased in the future because the initial capital is being eroded by the amount of its return. Income trust distributions can also fluctuate with business conditions and even disappear if the company is not earning enough money or if it has returned all the initial capital to investors. The potential for fluctuations in payout ratios makes income trusts ill suited for Registered Retirement Income Funds (RRIFs). Income trusts are under pressure to maintain distributions to unit holders but they could decrease them if the underlying business does not have enough money to pay them. An unexpected cut in distributions will have a negative impact on the trust unit price. The uncertainty regarding distributions from income trusts makes them much more risky than bonds. Therefore, income trusts are not a suitable replacement for bonds. Stocks and income trusts are similar in the sense that their return depends primarily on their earnings from businesses. Income trusts should be evaluated like individual stocks for their future earnings. Sector and company specific characteristics must be analyzed to determine the risk of a particular income trust. Two main differences exist between income trusts and regular equities. © Canadian MoneySaver • PO Box 370, Bath ON K0H 1G0 • 613-352-7448 • www.canadianmoneysaver.ca March 2004 First, a public company must pay taxes from its income, whereas income trusts pay no tax. This allows investors to avoid double taxation inherent in the Canadian tax system. Second, income trusts tend to be less risky than standard equities because companies that convert to the income trust structure are usually in maturing industries. These firms have high and predictable cash flows. They want to distribute as much of their cash flow as possible while minimizing taxes. High payouts are beneficial for investors. Many studies have shown the advantages of high payout ratios because they encourage management to make careful spending decisions and to operate the firm in a manner that maximizes the income streams to investors. For companies that do not need capital to finance growth, converting to an income trust structure is a tax-efficient way to distribute earnings to investors. Income trusts are, therefore, usually less risky than standard equities but they also have limited growth potential. The risk of income trusts fall between that of bonds and regular equities but that will also depend on the specific characteristics of the income trust. The first factor to look at in order to evaluate risk is to consider the type of income trust. There are four main categories of income trusts. Resource trusts and real estate income trusts (REITs) used to dominate the income trust market. However, companies in other sectors have converted into income trusts. Utility and business trusts are widely available now. Resource trusts represents 26% of the income trust market in Canada. The resource sector is made up of oil and gas companies. This sector has performed very well in the past few years. The global economic recovery has pushed commodity prices higher, especially oil prices. This sector is vulnerable to decreases in the price of crude oil. However, according to the S&P income trust rating system, oil and gas trusts have the highest variability and lowest sustainability of distributions, compared with other trusts. Resource trusts are vulnerable to decreases in the price of crude oil. In addition, high capital costs threaten distribution payments and the sector faces rapid depletion of its resource. Some of the large resource trusts include Pengrowth Energy Trust, Enerplus Resource Fund, ARC Energy Trust and Primewest Energy Trust. REITs constitute more than 20% of the income trust market. Like resource trusts, they have been performing very well since 2002. This sector is sensitive to interest rate movements. Low interest rates have greatly contributed to the excellent performance of REITs but their performance also depends on the state of the economy. Hotels’ profits are linked to business travel while earnings from apartment complexes and property management companies depend largely on vacancy rates. H&R Real Estate Investment Trust is becoming one of the biggest REITs. H&R has large cli- ents like Wal-Mart and Home Depot. Utility trusts have also grown in importance. They represent 14% of the income trust market. Utility trusts are made up of power generation, pipeline and telecommunication firms. Power generating and pipeline trusts are particularly sensitive to fluctuations in interest rates. Consumer demand will also affect the earnings of utility firms. TransAlta Power L.P., Pembina Pipeline Income Fund and Energy Savings Income Fund are a few examples of utility trusts. Business trusts are now dominating the income trust market, making up about 40% of the market. Just like utility trusts, the risk of a business trust depends on the industry it operates in and specific characteristics of the firm. Business trusts include all kinds of industries like fast food chains, luxury hotels, mattress manufacturers and fertilizer producers. The Yellow Pages Income Fund is considered to be the largest issuance of income trust units ever made in Canada with a 1-billion dollar initial public offering in 2003. There are several types of risks to consider when investing in income trusts including interest rate, sector and company specific risks. The quality and sustainability of earnings is an excellent indicator of risk. One concern is that the income trust may have to cut distributions if they do not have enough cash flow to pay them. Dominion Bond Rating Service (www. dbrs.com) rates income trusts on their ability to maintain distributions. Two other risks are specific to income trusts. Although unlikely, the tax loophole could one day be eliminated. Additionally, unlike investors in bonds and equities, income trust unit holders have unlimited liability. Unit holders may be liable beyond the value of their initial investment. Unlimited liability increases the risk of income trusts. However, the liability issue and other concerns may be resolved in the near future by the government. Buying a single income trust is like owning only one stock as you lack proper diversification and expose yourself to the risk of making a bad choice. Income trusts are relatively new investment products. Like any new product, there is a learning curve. Since the income trust market is evolving rapidly and income trusts have specific risks attached to them, it may be more efficient to have a professional manager select individual income trusts for you. Unless you are familiar with income trusts and are able to diversify your portfolio within this asset class yourself, income trust mutual funds may be the best solution to invest in this new asset class while minimizing risk. Income trust mutual funds allow investors to diversify within this new asset class and to take advantage of the expertise of a professional manager specializing in income trusts. As with all mutual funds, income trust mutual funds can greatly differ from fund to fund. With four categories of income © Canadian MoneySaver • PO Box 370, Bath ON K0H 1G0 • 613-352-7448 • www.canadianmoneysaver.ca March 2004 trusts to choose from, fund managers can decide to overweight or underweight some sectors. Before investing in an income trust mutual fund, it is important to consider the sector allocation of the fund as well as the manager’s ability to select high quality income trusts. Some of the largest diversified income trust funds include CI Signature High Income, Dynamic Focus Plus Income Trust, GGOF Monthly Income, Renaissance Canadian Income Trust, Talvest Millenium High Income, Bissett Income, and Elliott & Page Monthly High Income. Income trusts are very different from bonds and equities. Returns from income trusts have their own patterns and are affected by several factors. Income trusts offer several benefits to its unit holders including tax savings and a new asset class to diversify a portfolio. The unlimited liability issue will be resolved soon, which will attract many institutional investors who have shied away from income trusts because of this issue. Increase in demand for income trusts could extend the great performance of income trusts into 2004. However, bear in mind that like any asset class, income trusts have their ups and downs. Higher interest rates and a renewed enthusiasm for equities could negatively impact their performance. Income trusts tend to perform better in down markets. Furthermore, income trusts are not a good substitute for bonds. Efficient diversification of your portfolio in and within each asset class is important to reduce portfolio risk. Rachel Michaud, MBA, CFA, SRM Consultants, Mississauga, ON (905) 273-7435 [email protected] A Selection of Income Trusts Ranked by Yield RESOURCE INCOME TRUSTS Name Paramount Energy Trust APF Energy Trust NAV Energy Trust Harvest Energy Trust Pengrowth Energy Trust Units ARC Energy Trust Units Enerplus Resources Fund Symbol PMT.UN AY.UN NVG.UN HTE.UN PGF.UN AET.UN ERF.UN Yield 22.08% 18.01% 18.00% 17.96% 13.96% 12.10% 11.08% BUSINESS INCOME TRUSTS Name Westshore Terminals Income Fund Custom Direct Income Fund Prime Restaurants Royalty Income Fund Sun Gro Horticulture Income Fund Rainmaker Income Fund Hot House Growers Income Fund Yellow Pages Income Fund Symbol WTE.UN CDI.UN EAT.UN GRO.UN RNK.UN VEG.UN YLO.UN Yield 14.29% 11.96% 11.52% 11.37% 11.35% 11.10% 7.32% REAL ESTATE INCOME TRUSTS Name Lanesborough Real Estate Investment Trust TGS North American Real Estate Investment Trust InnVest Real Estate Investment Trust Morguard REIT Dundee REIT H&R Real Estate Investment Trust RioCan Real Estate Investment Trust Symbol LRT.UN NAR.UN INN.UN MRT.UN D.UN HR.UN REI.UN Yield 10.87% 9.92% 9.66% 9.20% 8.84% 7.07% 7.05% UTILITY INCOME TRUSTS Name Heating Oil Partners Income Fund Amtelecom Income Fund Clean Power Income Fund KeySpan Facilities Income Fund Boralex Power Income Fund Pembina Pipeline Income Fund TransAlta Power L.P. Symbol HIF.UN AMT.UN CLE.UN KEY.UN BPT.UN PIF.UN TPW.UN Yield 9.76% 9.63% 9.42% 8.65% 8.45% 7.90% 7.82% Source: http://www.investcom.com/incometrust.htm © Canadian MoneySaver • PO Box 370, Bath ON K0H 1G0 • 613-352-7448 • www.canadianmoneysaver.ca March 2004